One item we often discuss in strategic planning sessions is the rate environment. Board and management team members are rightfully concerned with rates, as strategy can often be undermined if rates move in unexpected ways.
In preparing for planning sessions, we take a look at Fed Futures as a means of working through various interest rate scenarios. In this post, I thought I would share the graphing process we use in our preparations.
30 day Federal Funds Futures are published by the Chicago Board of Trade, and are readily available via the CBOT website. If you browse to the site, however, you won't see what you would consider an actual representation of where the fed funds rate is today vs. where it is headed. If that is what you expect, you will be surprised to see that fed futures are listed at 98.0250. Imagine a fed funds rate that high!
In our graph, and this is the first thing you need to do if constructing your own graph or spreadsheet, we take the latest price and subtract 100. The result is something more much more familiar. Given that calculation and today's CBOT number for May, 2008 we see a rate of 1.975 - very close to the current fed funds target rate of 2.00.
At this point, you could carry that calculation through each month listed on the CBOT page to get a rough approximation future fed funds rates, but a common practice it to add a basis point to the rate for each month following the current month. For example, in June you would add .001, in July .002. We track this in a table, and add the basis point premium to the last posted price for that month, and then make the subtraction mentioned above.
Here is an example of the table:
You can then graph the results, which is much easier on the eyes and, let's face it, a much better tool to use to facilitate a discussion on the rate environment. When using this process, the graph of the latest CBOT data will look something like this:
Now of course there are a multitude of factors and scenarios that can push rates in either direction and it is impossible to consider them all. However, the picture, given what we know today, is a reliable indicator.
Now, how can you use this data? In a strategic sense, you can discuss if you are positioned for the scenario pictured in the futures graph. Right now the market expectation is for rates to turn up in the October/November timeframe. You can question whether your balance sheet will positively withstand the increase. You can discuss how the change will impact your volume. You can also discuss whether certain strategies should be accelerated to either blunt the impact of rising rates or take first advantage of the rise.
Just to be clear, I don't suggest taking the rate "prediction" at face value. Rather it is a tool to use to spark executive-level and board-level discussion about possible scenarios and the appropriate strategic response.
Happy charting!
